MACRO FX RESEARCH Singapore D 23 Jun 2015 FX Insight SGD: Playing Catch-Up To 3-Month SIBOR? The recent run-up in the 3-month SIBOR amid dollar strength as Fed prepares a lift-off in its fund rate while at the same time the USD/SGD has been quite resilient hovering around the 1.32-1.35 region. This begs the question whether the strength in the SGD has been overdone and a correction due. Our analysis shows that UIP long term condition holds in the Singapore context with the difference domestic interest rates and US interest rates largely explained by the expected appreciation of the S$ against the US$. At the same time, the residuals from our UIP estimation suggested that the expected change in the exchange rate cannot be explained by just interest rate differentials alone. The UIP residuals suggest that aside from interest rate differentials, risk premia could also play a role in explaining some of the deviations from the UIP conditions. The results reinforce our USD/SGD outlook for the rest of the year and allow us to keep our current USD/SGD forecasts into 2016 intact. With respect to the SGD/MYR, the potential for further weakness in the SGD against the dollar ahead, opens up the possibility that the SGD/MYR, which is currently inching to uncharted territories above the 2.80-handle, could see some relief. Should the USD/MYR maintain its current trajectory or remains stable, we could see the SGD/MYR come off from its historic highs back towards more familiar levels around 2.70-2.75. GM FX Research Saktiandi Supaat saktiandi@maybank.com.sg (+65) 63201379 Leslie Tang leslietang@maybank.com.sg (+65) 63201378 Fiona Lim Fionalim@maybank.com.sg (+65) 63201374 Christopher Wong wongkl@maybank.com.sg (+65) 63201347 Rise In 3-month SIBOR & USD/SGD Resilience The recent run-up in the 3-month SIBOR (3MSIBOR) amid dollar strength as Fed prepares a lift-off in its fund rate while at the same time the USD/SGD has been quite resilient hovering around the 1.32-1.35 region. This begs the question whether the strength in the SGD has been overdone and a correction due. Using the Uncovered Interest Parity (UIP) conditions, we attempt to determine how much the SGD needs to adjust to equate with interest rates, particularly amid expectations of a Fed fund rate lift off in Sep 2015. Exchange Rate Management and Interest Rates the Trilemma In Singapore, where monetary policy is synonymous with exchange rate policy, the intermediate target of monetary policy is the trade-weighted exchange rate. The choice of the exchange rate as the target instrument of monetary policy therefore imposes a SEE PAGE 8 FOR IMPORTANT DISCLOSURES
SGD: Playing Catch-Up To 3-Month SIBOR? constraint on MAS ability to influence interest rates at the same time. While any central bank can intervene in the money and foreign exchange markets to simultaneously affect both interest rates and the exchange rate, this could only be done at best for a very short period of time. For instance, if MAS raises interest rates by reducing the amount of liquidity in the interbank market, this will make SGD deposits more attractive and that other things equal would lead to a rise in the demand for SGD. Capital would flow in from abroad as economic agents take advantage of the higher yield on SGD assets. This could lead to undesired movements in the SGD. Capital flows therefore will act to frustrate any inconsistent setting of both interest and exchange rates. Accordingly, given that Singapore does not generally control cross-border capital flows, the management of the SGD must imply relinquishing control over domestic interest rates and money supply. As such, within Singapore s well-defined framework, domestic interest rates are market-determined, i.e., they are endogenous. They are largely determined by foreign (US) interest rates and market expectations of the movement of the USD/SGD. Indeed, domestic interest rates have closely tracked the foreign (US) interest rate. This relationship is called the Uncovered Interest Rate Parity (UIP). The UIP is essentially an arbitrage condition, similar to the wellknown Purchasing Power Parity condition. Whereas PPP postulates arbitrage activity in the goods market, UIP is concerned with arbitrage in financial markets. The uncovered interest parity (UIP) implies equality between the domestic and foreign interest rates after capital gains/losses involved in exchange rate movements are taken into account. It assumes that arbitrageurs are sufficiently active and numerous to drive interest rates to equality in the above sense. That is, financial markets are supposed to produce the result (plus in this example the UIP assumes there are no risks premiums involved in the calculation): (1+ rf) = (1+rs) x [(SGD/USD(+1))/(SGD/USD)] where rf is the short term foreign interest rate or US$ interest rate and rs is the short term Singapore interest rate. To put it in an easier format: foreign (US$) interest rate = domestic (S$) interest rate + expected change in the US$ per S$ exchange rate In the simple form above, the uncovered interest rate parity requires that the foreign interest rate is equal to the sum of the domestic interest rate and the time rate of appreciation of the S$. If the S$ is expected to depreciate, then a capital loss rather than a gain is expected and the expected change in the US$ per S$ exchange rate is negative. In such a case, the Singapore interest rate must adjust to be sufficiently higher than the foreign rate to compensate for the prospective capital loss. So in this case, the Singapore interest rate is affected by both foreign interest rates and expected changes in the S$ vis-a-vis foreign currency. To see this, let us consider a simple example. Suppose domestic interest rates were 1% p.a. and foreign rates were at 5% p.a. Suppose also that the market expects the S$ to appreciate by 2% p.a. This would then open up arbitrage opportunities since domestic residents can earn a higher rate of return (of 5% p.a.) by investing in the foreign currency for a year and then converting the proceeds back to the domestic currency (and incur an exchange loss of 2%), giving rise to a net gain of 3%, which is considerably better than the 1% return available domestically. Alternatively, measured 23 Jun 2015 2
2/8/1999 2/8/2000 2/8/2001 2/8/2002 2/8/2003 2/8/2004 2/8/2005 2/8/2006 2/8/2007 2/8/2008 2/8/2009 2/8/2010 2/8/2011 2/8/2012 2/8/2013 2/8/2014 1/1/2000 1/10/2000 1/7/2001 1/4/2002 1/1/2003 1/10/2003 1/7/2004 1/4/2005 1/1/2006 1/10/2006 1/7/2007 1/4/2008 1/1/2009 1/10/2009 1/7/2010 1/4/2011 1/1/2012 1/10/2012 1/7/2013 1/4/2014 1/1/2015 SGD: Playing Catch-Up To 3-Month SIBOR? in foreign currency terms, domestic investors will only get a return of 3% (1% interest and 2% currency gain) vs. 5% if they put their money in foreign currency deposit. This discrepancy from UIP would induce shifts in capital flows (viz. flows out of S$) that would lead to changes in interest rates (rise in S$ interest rates) until the UIP condition is satisfied. Historically, Singapore s interest rates have been persistently below that of foreign rates, reflecting an expected, and continuous, appreciation of the S$ (Chart 1). In the fifteen year-period to 2015, the gap between the domestic 3-month interbank rate and the corresponding US interest rate was about 1%-point. Chart 2 shows that ex-post, the uncovered interest differential (i.e., the sum of the interest rate differential and the change in the exchange rate) generally lie within one standard error bounds, except during the volatile period of the Lehman Brother crisis/great Recession. This casual observation suggests therefore that the UIP condition generally holds in Singapore and that the trilemma is still very much operative in the domestic economy, in the context of an open capital account and a large offshore financial center. Chart 1: SGD & 3-month SIBOR & 3-Month US LIBOR Chart 2: 3-month Uncovered Interest Differential 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 1.90 1.80 1.70 1.60 1.50 1.40 1.30 1.20 % 3.00 2.50 2.00 1.50 1.00 0.50 0.00-0.50-1.00-1.50-2.00 +1 std dev -1 std dev 3M US Libor 3M SIBOR 3M SOR USD/SGD (rhs) Source: Bloomberg, Maybank FX Research Source: Bloomberg, Maybank FX Research In the past decade or so, the gap between the domestic 3-month SIBOR interbank rate and the corresponding US interest rate was about 600bps. More recently it has narrowed and for a brief period since late 2009, the S$ SOR has gone above the US$ LIBOR (Chart 1). Our analysis shows that the UIP long term condition holds for Singapore, and domestic interest rates continue to trade at a discount to US interest rates, with the difference largely explained by the expected appreciation of the S$ against the US$. While the UIP condition holds here, there is nonetheless an important change in the magnitude of the ex-post S$ appreciation between the precrisis and post-great Recession crisis periods. Although the differential between domestic and US interest rates were nearly the same for these two periods, the actual appreciation of the S$/US$ was quite different. Between 2000 and 2007, the S$ rose by almost 14.3% vis-a-vis the US$, compared to a decline of 0.4% between 2010 and 2015. Table 1 below shows the cumulative effects of movements in interest and exchange rates before and after the Great Recession. 23 Jun 2015 3
SGD: Playing Catch-Up To 3-Month SIBOR? Table 1: Cumulative Exchange & Interest Rate Movements Cumulative Effects (%) (a) (b) Interest Rate Exchange Rate UIP = (a) + (b) Differential Appreciation 2000-2007 -1.7-12.6-14.3 2008-2009 -0.8 2.8 2.0 2010-2015 1.4-1.0 0.4 Source: Maybank FX Research The observations suggest that market participants had to some extent overestimated the appreciation of the S$ in the first half of the 2000s but the subsequent overestimation of the currency appreciation after the crisis has fallen. Thus the UIP statistic i.e., the interest rate differential plus the expected change in the US$/S$ exchange rate remained negative in the pre-crisis period and less-negative in post-crisis. Nevertheless, these deviations were not large enough on an annual basis to render the UIP condition inoperative in Singapore over the past 7 years or so. The UIP condition tells us that any differences in interest rates between two countries should be reflected in the expected change in spot exchange rate. In a perfect market, the interest rate differentials should equate to the anticipated change in the spot exchange rate. Any deviation from this UIP condition could suggest the presence of an exchange rate risk premium. UIP Model Estimation And Results We estimated the UIP model and used it to forecast the possible trajectory of the USD/SGD given widening US3MLIBOR-3M SIBOR differentials as the Fed prepares for a fund rate lift-off, which we expect to take place in Sep 2015. The recent rebound in the USD/SGD is likely to again give pause to the slide in domestic interest rates. The eventual rise in dollar funding rate in 2015 and our expectations of a Fed rate hike in Sep 2015 could see domestic interest rates accelerate once again. Our 3-month SOR & SIBOR forecasts for end 2015 are at 1.03% and 1.08% respectively. Going into 2016, we could see domestic interests rates accelerate even faster with the possibility of 3-month SOR & SIBOR by end 1H 2016 at 1.53% and 1.57% respectively (Table 2). Table 2: USD/SGD & US LIBOR/SIBOR/SOR Forecasts End Q1 End Q2f End Q3f End Q4f End Q1f End Q2f 2015 2015 2015 2015 2016 2016 USD/SGD 1.38 1.35 1.39 1.36 1.35 1.33 3 Mth US LIBOR 0.27 0.32 0.52 0.52 0.77 1.02 3-Mth SOR 0.77 0.80 1.05 1.03 1.29 1.53 3-Mth S$SIBOR 0.81 0.84 1.09 1.08 1.33 1.57 Source: Maybank FX Research 23 Jun 2015 4
1/1/2015 1/2/2015 1/3/2015 1/4/2015 1/5/2015 1/6/2015 1/7/2015 1/8/2015 1/9/2015 1/10/2015 1/11/2015 1/12/2015 SGD: Playing Catch-Up To 3-Month SIBOR? Our results showed that the derived USD/SGD is currently hovering above the actual USD/SGD, which suggest that the exchange rate could be overvalued according to UIP (Chart 3). Adjustments to the current levels of the spot USD/SGD is possible and further up-moves cannot be ruled out. Chart 3: USD/SGD Appears To Be Overvalued 1.40 1.38 1.36 1.34 1.32 1.30 1.28 1.26 1.24 1.22 1.20 Forecast Source: Bloomberg, Maybank FX Research Chart 4: Risk USD/SGD Premium (Actual) Have Risen USD/SGD Forecast USD/SGD (Fitted) Source: Maybank FX Research At the same time, the residuals from our UIP estimation suggested that the expected change in the exchange rate cannot be explained by just interest rate differentials alone. The UIP residuals suggest that aside from interest rate differentials, risk premia could also play a role in explaining some of the deviations from the UIP conditions. Our results showed that the deviation from the UIP condition is volatile (Chart 4). We took the average values of the UIP residuals during the Great Recession period (2008-2009) and post-great Recession till the present (2010-2015) to see if the average risk premium has changed. Our calculations show that since the Great Recession till today, the average risk premium has risen to positive territory as compared to the period during the Great Recession. This rise in the risk premium suggested that there could be even more upside to the USD/SGD as predicted by the UIP model. 23 Jun 2015 5
1/1/2008 1/5/2008 1/9/2008 1/1/2009 1/5/2009 1/9/2009 1/1/2010 1/5/2010 1/9/2010 1/1/2011 1/5/2011 1/9/2011 1/1/2012 1/5/2012 1/9/2012 1/1/2013 1/5/2013 1/9/2013 1/1/2014 1/5/2014 1/9/2014 1/1/2015 1/5/2015 SGD: Playing Catch-Up To 3-Month SIBOR? Chart 4: UIP Residual & Risk Premium 2.5 2.0 1.5 1.0 0.5 0.0-0.5-1.0-1.5 Residuals Average Risk Premium (2010-2015) Average Risk Premium (2008-2009) Source: Maybank FX Research Implications for USD/SGD & SGD/MYR The results from our UIP model suggest that the USD/SGD appears to be overvalued. Furthermore, the average exchange rate risk premium has increased in the aftermath of the Great Recession. Taken together, the model seems to suggest that there is a potential for further upside in the USD/SGD from current levels going forward, especially as the Fed fund rate lift-off approaches. The results here reinforce our USD/SGD outlook for the rest of the year, namely that the pair would end the 2Q and 3Q at 1.35 and 1.39 respectively with the possibility of an overshoot beyond 1.39. Thereafter, the USD/SGD should settle lower at 1.36 by end-2015 and then towards the 1.32-levels into end-2016. With respect to the SGD/MYR, the potential for further weakness in the SGD against the dollar ahead, opens up the possibility that the SGD/MYR, which is currently inching to uncharted territories above the 2.80-handle, could see some relief. Should the USD/MYR maintain its current trajectory or remains stable, we could see the SGD/MYR come off from its historic highs back towards more familiar levels around 2.70-2.75. Technicals Potential Pullback Towards 2.7350 Levels SGD/MYR could face further upside pressure possibly towards 2.80-2.82 levels. But we caution for potential technical correction given that daily stochastics is now in overbought areas while daily momentum appears to be waning. Given the 18 sens run-up since Feb 2015, a technical pullback could see the cross ease towards 2.7350 levels (38.2% Fibonacci retracement of 2015 trough to peak). 23 Jun 2015 6
SGD: Playing Catch-Up To 3-Month SIBOR? Chart 5: Caution for Technical Pullback Source: Bloomberg, Maybank FX Research 23 Jun 2015 7
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